Duffie on speculative trading

Dan Crawford | February 26, 2010 9:12 am

by Linda Beale

Duffie on speculative trading (Part one of a series)

In today’s Wall St. Journal, Darrell Duffie, a finance professor at Stanford’s business school, argues “In Defense of Financial Speculation” (Wall St. J., Feb. 24, 2010, at A15). (Rdan here…AB posting is Feb. 26)

According to Duffie, speculators are beneficial. Here’s his argument.

1) speculators absorb risk that others don’t want, permitting investors to hedge their positions

2) speculators provide information about invetments–if they buy, fundamentals appear favorable; if they sell, fundamentals are not. That information helps market prices be more accurate.

3) speculation–defined as “accurately forecasting an investment’s fundamental strength or weakness”–is not the same as manipulation–defined as “when investors ‘attack’ a financial market in order to profit by changing the value of an investment.

Duffie admits that speculation “is not necessarily harmless. If a large speculator does not have enough capital to cover potential losses, he could destabilize financial markets if is position collapses.”

Are Duffie’s arguments strong enough to think, as he suggests, that curbing speculation in the credit default market isn’t necessary? Note that item 2 stems directly from the “efficient markets hypothesis”–that markets price items appropriately through sharing of information. But what we know suggests this isn’t true. We have an entire vocabulary for talking about the fact that without stabilizing intervention and protective regulation, market pricing–and the kinds of speculation that Duffie praises–tends to lead to market bubbles. The housing markets are a good example. People thought that housing was a good investment. Speculators got into housing to “flip” houses to make a profit. Other speculators bet on the housing market through collateral debt obligations and other types of mortgage backed securities. These were often tied with credit default swaps, which the counterparty banks saw as a “safe” bet that meant steady premiums without any payback day. The speculation is what made the housing market into a bubble. And when the bubble burst, many of the speculators had to be backed by the government to keep the financial system going. Prices weren’t an accurate reflection of value. They were only an accurate reflection of the casino mentality estimation of value. And the increased speculation in housing didn’t mean there was more accurate evaluation of fundamental values. It meant, in fact, that there was less and less accurate information, as lenders eager for loans to securitize accepted shoddier products and pushed for shoddier lending standards and as the securitization market’s key characteristic–the lack of a relationship between lender and debter–became the key variable that made speculative investment in housing too easy because the loss risk could, theoretically at least, be offloaded to the investors, guarantee counterparties and other third parties. Combine the speculative “casino” mentality with the lack of relationships between lending banks and buying families and you have a winner take all casino system where nobody but the winners are served. Here, that ended up being the big investment banks.

What about item 1–the hedging function that speculators serve by taking risks that others want to offload. Well, our system treats that as a plus. It is one of the factors that permits securitization and one of the factors that permits globalization of the risk–spreading it around in little pieces of losses. We tend to think that being able to hedge the potential future risks of a business is a definite priority. If we need energy a year out, we can buy futures. But is that really a plus? Would we be better off if the lender continued to bear the risk against the lender’s equity capital? Odds are loans would be harder to get but surer to pay off. And, yes, we’d need some ability to lubricate the pipes during financial difficult times. But notice that all of that speculative hedging function hasn’t done much to ensure that small businesses and working families are able to borrow now when they should be able to. So if it doesn’t function well when there is a financial crisis, why think that it is really working well when there isn’t?

And item 3–that speculation is ok, it’s just market manipulation that we have to worry about? Duffie suggests that there is a bright,easily definable line separating the two. I’d argue that there is not. Speculation becomes manipulation when it is too big, when there is too much risk and not enough capital to absorb it, when it creates a deceptive appearance of rationality but represents irrational exuburence. Speculation is just manipulation writ smalll–since speculation is a bet against what appears to be a market trend and making the bet can shift the market. Casino gambling doesn’t really look to fundamentals; it looks to perceptions of fundamentals. So long as the odds are breaking the gambler’s way, the gambler doesn’t care whether it’s rotten at the core or not. And of course, one of the problems with financial derivatives generally, and their use as speculative instruments in particular, is that they make it possible to finely tune financial scams–shadow banking systems can exist for countries (and the globe), and shadow financial realities can exist, since derivatives can be used as subterfuge. Financial transparency is one of the keys to maintaining democratic institutions without permitting country and system to be captured by ruling oligarchies.

Maybe I’ll wake up tomorrow and regret this post. Perhaps I’m a Luddite in tax prof clothing. But I can’t shake the thought that globalization–the idea that corporate entities should be able to operate their business world-wide without any “barriers” from the nations themselves–is at the heart of our systemic economic problems. The rage at the base of the tea party movement is real–it has been misdirected at government, as though government were the source of the problems, when it should have been directed against the Big Business mentality that casts morality aside and considers profit the only god–community, workers, and product quality/service be damned. The tea partiers’ rage itself is real, because people are so fed up with having no real choices, at being at the mercy of multinational corporations that set their own terms and, often, have near monopolies. This is especially true with health insurance, where the lightly regulated industry is made up of a few giants who often dominant their markets, leaving a typical person little ability to “shop” for a better deal. Even where you shop, once you create a business relationship you are in many ways at the mercy of the corporate giant. They change prices when they please, they charge ridiculous add-on fees for services that cost them only a small fraction of the fees they charge, they hide information and manipulate their clients–from cable providers to banks to mortgage lenders. They are no longer local, and they no longer care about your community or you as a client. It seems to me that if we want businesses that are more responsive to the typical person, we need businesses that are smaller, not businesses that are bigger. We need more Mom and Pop stores and less Wal-Martization of the country. Because in the long run, a company that is run like Walmart–to make the biggest profit possible for its owners, come hell or high water and without concern for the communities or people in them–may be able to offer goods at lower prices but it also offers jobs at lower pay. If we had those same goods sold by smaller stores that hired in the community and lived in the community, we might pay more but the employees would be paid more. In the long run, that is the secret of quality of life–having a population that has decent jobs so that they can afford to buy life’s necessities and a little more.

I suspect that there will be many others who join Duffie in defending financial speculation. But I find that his arguments about risk absorbing and pricing information fall short of convincing. If speculators really absorbed risk, there would be no worry about the risks falling back to the taxpayers. But in the case of the financial crisis, it was the taxpayers, ultimately, who got hit with the risk. There were many times more credit default swaps on debt than there was debt outstanding, creating an illusion of a well-diversified financial system with supports all around. But AIG held a significant percentage of the counterparty risk, and all the banks were dealing with AIG or some other counterparty that held significant amounts of risk. All that speculation didn’t do more than link us all together in one big Ponzi scheme. And while there was lots of information about what the speculators were buying, the result wasn’t widespread increase in fundamental knowledge–instead, it was “he’s getting rich with those mortgage-backed securities, I need to get in on that too” or “Bear Sterns is making lots of money with its securities packages; maybe I can get some of those subprime mortgage deals going for my bank” or “look at how much he made flipping that house in just two months; I gotta get some of that”.

Linda Beale crossposted with ataxingmatter

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